Statement of Jonathan Barry Forman

Professor of Law
College of Law
University of Oklahoma
Norman, Oklahoma

 

for the

The National Commission on Restructuring the Internal Revenue Service

 

Date: March 19, 1997

 

Co-Chairmen J. Robert Kerrey and Rob Portman:

 

I am pleased to submit this statement for the record you are compiling on Restructuring the Internal Revenue Service. I am submitting this statement in my individual capacity as a Professor of Law at the University of Oklahoma College of Law where I teach courses on tax law and write about federal tax policy. The purpose of this statement is to suggest ways to simplify the tax system for low-income taxpayers and for the Internal Revenue Service.

 

HOW TO SIMPLIFY THE TAX SYSTEM FOR LOW-INCOME TAXPAYERS AND FOR THE INTERNAL REVENUE SERVICE

 

I. INTRODUCTION

 

According to the Census Bureau, more than 38 million Americans live in poverty. The principal federal taxes affecting these low-income individuals are the individual income tax and the Social Security taxes. Once the earned income credit is taken into account, however, relatively few low-income individuals actually have a net federal tax liability at the end of the year.

Nevertheless, the current federal tax system requires virtually all low-income individuals to file income tax returns, if only to recover refunds of their over-withheld taxes. All in all, the current federal tax system imposes heavy costs and burdens on both low-income individuals and the Internal Revenue Service. Consequently, simplification of the tax system holds the promise for significant economic and equitable gains.

What can be done to simplify the federal tax system for low-income individuals and for the Internal Revenue Service? This statement discusses two of the more promising approaches: 1) moving to a return-free, final withholding tax system; and 2) integrating the income and Social Security taxes into a comprehensive income tax.

 

II. THE IMPACT OF THE FEDERAL TAX SYSTEM ON LOW-INCOME INDIVIDUALS

 

Because of standard deductions, personal exemptions, and the earned income credit, relatively few low-income individuals pay any income taxes. On the other hand, because the Social Security tax system has no standard deductions or personal exemptions, many low-income individuals are required to pay Social Security taxes. Fortunately, the earned income credit offsets the Social Security tax liabilities of most low-income individuals. Consequently, relatively few low-income workers owe any federal taxes at the end of the year. (See the Appendix for a detailed explanation of the taxation of low-income individuals.)

Unfortunately, even though relatively few low-income workers owe any federal taxes, most must file income tax returns and fill out Schedule EIC to recover their over-withheld taxes and their refundable earned income credits. The problem is that filing returns is burdensome and expensive for low-income workers and for the Internal Revenue Service.

For example, of the 115.9 million individual income tax returns filed for the tax year 1994, some 82 million got refunds, and 28 million showed no income tax liability whatsoever. Also, that year more than 14.6 million low-income workers received earned income credit refunds in excess of their income tax liabilities. All in all, more than 45 million taxpayers with adjusted gross incomes below $15,000 had to file returns for 1994, even though most owed little if any tax.

Moreover, millions of Americans need help preparing their income tax returns. For example, more than 57 million taxpayers used paid preparers for their 1994 tax returns. That's about half of all individual taxpayers. Even more astonishing, more than 1.5 million taxpayers paid private preparers to help them fill out 1040EZ forms, and more than 5.7 million taxpayers paid preparers to help them fill out 1040A forms. Furthermore, fully half of earned income credit recipients use paid preparers. At $30 or more for return preparation -- and an additional $15 to $40 fee for electronic filing, that means millions of dollars are going from low-income workers to private preparers.

 

III. IT'S TIME TO FUNDAMENTALLY REVAMP THE TAX SYSTEM

 

Elsewhere, I have discussed a number of ways to tinker with the federal tax system in order to simplify its operations. But here I want to focus on two fundamental changes that could simplify the tax system for low-income taxpayers and for the Internal Revenue Service: 1) moving to a return-free, final withholding tax system; and 2) integrating the income and Social Security taxes into a comprehensive income tax.

 

A. MOVE TO A FINAL WITHHOLDING SYSTEM

 

The first approach would be to move to a so-called "final withholding" tax system. Final withholding tax systems are similar to return-free systems, except that they rely more heavily on withholding. Under a final withholding system, the amount withheld by employers and other income sources is the tax, thus eliminating the need for many taxpayers to file tax returns. Over 30 foreign countries use some form of final withholding, including Great Britain, Japan, Germany, and Argentina.

For example, in Great Britain, the income tax is withheld by employers under the British PAYE (Pay As You Earn) final withholding system. When an individual first becomes potentially subject to tax, an initial return must be filed so that the Inland Revenue can determine how much the employer should withhold. Thereafter, individuals with simple incomes and modest earnings are normally required to file a return only about once every five years. In 1994, for example, more than three-fourths of the 22.4 million taxpayers eligible for PAYE did not have to file tax returns.

Would a final withholding system work in the United States? A final withholding system could significantly reduce burdens on both taxpayers and the Internal Revenue Service. In its analysis of the issue, the General Accounting Office concluded that most taxpayers who now file 1040EZ returns (about 21 million in 1994) and many of those who now file 1040A returns (about 26 million in 1994) could be served by a final withholding system. Most of these people would no longer have to gather information, become familiar with tax laws, or prepare and file returns. The burden on the Internal Revenue Service would also be greatly reduced.

 

B. INTEGRATE THE INCOME AND SOCIAL SECURITY TAXES INTO A COMPREHENSIVE INCOME TAX

 

Another approach would involve better integrating the income and Social Security taxes. After all, much of the complexity of the current tax system results from imposing Social Security taxes on every dollar of earned income, and then using the earned income credit to offset those taxes for eligible low-income workers. It would be a lot simpler if the federal tax system simply did not collect Social Security taxes from low-income workers in the first place.

One option would be to add standard deductions and personal exemptions to the Social Security tax system. Another option would be to exempt the first $5,000 or $10,000 of earnings by any worker from Social Security taxation. While, under either or these two options, some special rules would be needed to ensure that the proper amount of tax is collected from workers with more than one job during the year, millions of other low-income workers would simply no longer need to file tax returns. Moreover, the paperwork burdens for many employers would also be reduced.

A more substantial reform would be to combine the individual income and Social Security taxes into a single, comprehensive income tax. Individuals with incomes below some poverty threshold would be exempt from tax. Consequently, millions of low-income individuals would no longer have to file tax returns. In effect, there would be a single, higher-yield income tax instead of the current bifurcated tax system. For example, an integrated tax system might be designed to impose, say, no tax on income below the poverty thresholds, a 25 percent tax rate on income from those thresholds up to $100,000 of income, and a 40 percent tax rate on income over $100,000.

 

IV. CONCLUSION

 

Millions of low-income Americans have no net federal tax liabilities, yet they are required to file income tax returns to recover refunds of their over-withheld taxes. Millions more have to keep records and file unnecessarily complicated tax returns to pay relatively little federal tax. This statement has outlined two approaches for dramatically simplifying the tax system for low-income taxpayers and for the Internal Revenue Service: 1) moving to a final withholding system; and 2) integrating the income and Social Security taxes.

It may not be possible to simplify the federal tax system for all individuals. But it should be possible to simplify the system for low-income individuals -- and for the Internal Revenue Service. I applaud your Commission's efforts.

 

Respectfully submitted,

 

Jonathan Barry Forman
Professor of Law

 

APPENDIX

 

The two tables in this Appendix show how the earned income credit offsets the income and Social Security tax liabilities of millions of low-income workers.

 

First, Table 1 compares the combined income and Social Security tax thresholds (i.e., net federal tax thresholds) of various family units with their poverty income guidelines. For example, consider the tax treatment of a typical family of four in 1997 -- a married couple with two children. Row 1 of Table 1 shows that this family unit's poverty income guideline for 1997 is $16,050.

 

TABLE 1. POVERTY LEVELS AND NET FEDERAL TAX THRESHOLDS AFTER THE EARNED INCOME CREDIT IN 1997, BY FAMILY SIZE, UNMARRIED INDIVIDUALS AND MARRIED COUPLES, IN DOLLARS

 

FAMILY SIZE

1

2

3

4

5

6

POVERTY LEVELS

7,890

10,610

13,330

16,050

18,770

21,490

SIMPLE INCOME TAX THRESHOLD
(BEFORE EARNED INCOME CREDIT)

6,800

12,200

14,850

17,500

20,150

22,800

INCOME TAX THRESHOLD
(AFTER EARNED INCOME CREDIT)

7,803

12,200

20,477

24,386

25,488

26,590

SOCIAL SECURITY TAX THRESHOLD

0

0

0

0

0

0

COMBINED INCOME AND SOCIAL SECURITY TAX THRESHOLD
(I.E., NET FEDERAL TAX THRESHOLD

4,340

4,340

16,422

20,118

21,027

21,485
 

Row 2 of Table 1 shows the simple income tax thresholds for family units of different sizes. These are determined by summing each family unit's standard deduction and its personal exemptions. For 1997, a married couple with two children can file a joint tax return and claim a $6,900 standard deduction and four $2,650 personal exemptions. Consequently, the couple will not have to pay any income tax unless its income exceeds its $17,500 simple income tax threshold ($17,500 = $6,900 + 4 x $2,650).

Row 3 of Table 1 shows each family unit's income tax threshold after taking into account the effect of the earned income credit. The earned income credit is a part of the income tax system which can offset a family unit's preliminary income tax liability. Consequently, taking the earned income credit into account can raise the income tax threshold for some family units. For example, for 1997, a taxpayer with two (or more) children can claim an earned income credit of up to $3,656. Therefore, taking into account the earned income credit, a typical married couple with two children will not actually owe any income tax until its income exceeds $24,386.

On the other hand, because the Social Security tax system has no standard deductions or personal exemptions, family units must pay Social Security taxes starting with their first dollar of earned income. Hence, Row 4 of Table 1 shows that zero is the Social Security tax threshold for all family units.

Finally, Row 5 of Table 1 shows the combined income and Social Security tax threshold (i.e., net federal tax threshold) for various family units. Because the earned income credit is refundable, it can offset not only individual income taxes, but also Social Security taxes. Consequently, a family unit will have no net federal tax liability until the sum of its preliminary income tax liability and its Social Security tax liability exceeds its earned income credit. For example, a typical married couple with two children will not actually have a net federal tax liability for 1997 unless its income exceeds $20,118.

 

Finally, Table 2 compares the 1997 federal tax thresholds and poverty income guidelines for heads of household with one to four children. Of note, a head of household is entitled to a standard deduction of $6,050 for 1997. All in all, Tables 1 and 2 show that the earned income credit offsets the income and Social Security tax liabilities of millions of low-income workers.

 

TABLE 2. POVERTY LEVELS AND NET FEDERAL TAX THRESHOLDS AFTER THE EARNED INCOME CREDIT IN 1997, BY FAMILY SIZE, HEADS OF HOUSEHOLD, IN DOLLARS

 

FAMILY SIZE

2

3

4

5

POVERTY LEVELS

10,610

13,330

15,050

18,770

SIMPLE INCOME TAX THRESHOLD
(BEFORE EARNED INCOME CREDIT)

11,350

14,000

16,650

19,300

INCOME TAX THRESHOLD
(AFTER EARNED INCOME CREDIT)

18,783

22,930

24,032

25,134

SOCIAL SECURITY TAX THRESHOLD

0

0

0

0

COMBINED INCOME AND
SOCIAL SECURITY TAX THRESHOLD
(I.E., NET FEDERAL TAX THRESHOLD)

15,063

18,917

19,826

20,735